Just when we thought that the credit crisis was blowing over, we are now getting hit by an even bigger issue — the relentless surge in oil prices. Oil prices have clearly broken out, surging past $135 and showing no signs of cooling.

As we all know by now, rising oil prices are an unadulterated negative, raising inflation, reducing growth and discretionary consumption. They also reduce the flexibility global central banks have in dealing with and reacting to growth shortfalls. With oil prices now firmly stuck at these elevated levels, the dreaded stagflation word has resurfaced in market participant's dictionary.

Intriguingly, there is at the moment a raging debate going on in financial market circles as to the reasons behind this surge in oil. The fundamental bulls led by Goldman and some savvy commodity funds argue that a chronic and worsening demand-supply mismatch can explain oil at $135. They argue that major EM consumers like India and China have not passed on the oil hikes and thus consumption is still not getting fully hit. Oil production continues to falter, with Russia, Mexico and many other large producers hitting peak production. Where oil is available, e.g. Venezuela and Iraq, there exist serious political constraints to getting these reserves out of the ground. Whatever capacity growth that we have seen in the past few years has mostly come from bio-fuels, natural gas liquids and synthetic oils.

Their fundamental point remains that oil prices will have to keep rising to balance the trend global GDP growth of 3.8-4 per cent, with oil production growth at best 1 per cent. Oil prices will keep rising till demand growth comes in line with production growth — it is as simple as that. The bulls believe that this fundamental alignment of incremental demand/supply will not happen till oil crosses $150 in the short term and eventually even higher. The movement of the long-dated oil prices (five-year prices are now around $120) also confirms the bullish outlook.

The bears are much more sanguine on the demand/supply outlook and are comparing the current spike to the internet boom of the 90s, with a total de-linking of the fundamentals with prices. They point to the fact that between 2004 and 2007, global demand growth has slowed from 3.6 mbd (million barrels per day) to .7 mbd; thus demand is now growing slower than non-OPEC production, which rose by .8 mbd in 2007 (source: ISI). With OPEC production continuing to grow, the bears point out that we will soon have nearly 5 mbd of spare capacity (half of Saudi Arabia). They also point to the persistent news that Iran and some others are chartering huge numbers of tankers to store crude, which they are unable to sell at current prices. How can you have shortages if Iran cannot sell what it produces today? The bears also point out how the bullish oil price scenario assumes no policy response from the OECD or large EM countries. If the US, for example, were to adopt European type fuel economy norms for the US car fleet, this alone will cut US fuel consumption by the equivalent of China's entire gasoline demand. At some stage China and India will pass on oil price hikes to their end consumer.

Another theory is that institutional investors in the form of large commodity index funds are the real reason behind the rise in prices of oil and more generally commodities across the board. In recent testimony before the US Congress, Michael Masters, a long short hedge fund manager, made this case in great detail. He pointed out that commodities have now become an acceptable asset class in which endowments, foundations and money managers of all hues wish to participate. They participate in the futures markets for commodities and through index funds to get portfolio diversification. As he states, at the end of 2003 there was $13 billion in commodity index funds , which has now grown to $260 billion. In many commodity futures markets, index funds are now the biggest players. In the first 52 trading days of this year, demand for commodity index funds grew by more than $55 billion.

While Masters has some good data in his testimony, and it is a worthwhile read (available on the net), he is in my opinion overstating the impact of these index commodity funds on the cash market and cash prices of these commodities. An index fund buys a futures contract for a commodity when money is first invested, and before the contract expires or needs delivery this same fund will reverse the original contract and buy another long dated one. Thus they do not affect the cash price of the commodity, which is based more on actual demand/supply. He also fails to explain why in many commodities like iron ore or steel, which are non-exchange traded and thus not in these fund's portfolios, prices have actually risen by a lot more.

I am a believer that oil prices in the long term are going to be at a new elevated level, and that supply constraints will be more binding than the ability of countries to find solutions to reduce demand. Prices will have to remain at levels where there is permanent destruction of demand, and where all types of alternatives, be it solar, wind, bio-fuel or nuclear, are economically viable.

Having said that, given all the hype around oil currently, there is a very high probability that we get a sharp correction in the near future, as the long trade is now getting crowded and the recent spike forced significant short covering.

This coming corrective phase should be used by the Indian authorities, to try and put our policy on oil pricing in order. We missed the opportunity to move to market-based pricing in 2003-2004, when oil was below $50, we have to use the coming correction to get a more market-oriented framework for fuel pricing. Obviously the current environment is not conducive politically to bring about any substantive change, but we have little choice. Any correction in petroleum prices will be shortlived, we have to accept that we are in an era where oil will remain far above accepted norms of pricing. We do not have an adequate policy framework in India to address permanently higher oil prices. When oil is above $100, band aid solutions of bonds and subsidies are not sustainable.